Pages

Beyond value traps: The value graveyard

He couldn't stop talking about the great deal he got on his boat. My friend purchased his boat over the internet from what he considered a sap Florida. The boat was supposedly in mint condition, everything was like new, it ran well. We looked at the same batch of pictures over and over as we listened to his savviness in buying cheap online. Since he didn't live in Florida he paid someone to tow the boat to Pennsylvania. It was there the problems started.

On the way back the boat trailer developed a problem with the wheel bearings. My friend explained it away as something simple that happens to trailers that sit a lot. He had a great reason too, in Florida boats are always in the water so the trailers rarely are used. Once the boat was back in Pennsylvania the list of repairs began to grow. That mint condition vinyl was a bit sun faded, it just needed to be replaced. Then there were some issues with the engine that required an overhaul. Some patches and paint and a number of other things were needed before the boat was sea-worthy. Suddenly this incredible deal my friend got on his boat wasn't such a great deal. He put so much money into the boat that if you added it all up it's likely he overpaid.

Investments can be like my friend's boat. A company looks great on the surface and even cheap, but after a little while the problems start to crop up. A bit of faded paint here, an old engine there, minor things, but all together they become a disaster. Investors like to refer to companies like these as value traps. Companies that appear to be cheap on a statistical basis, but once an investor has a little experience they realize the company isn't cheap at all, in many cases it's very expensive given the issues. Value investors who purchase shares find themselves trapped in a bad situation.

Value traps are bad, but they aren't the worst. With a value trap in most cases an investor can escape with a loss and move on. There is a category of investments so bad that they make value traps appear attractive, these are stocks in the value graveyard. Perpetually cheap on a statisitical basis but with negative factors so large investors would be lucky if they merely experienced a loss. Rather they're likely to have their capital tied up forever in a company who's management is slowly destroying value.

Value traps are usually companies caught in a shifting industry that fail to adapt. A company like Radio Shack that believed we'd still be sodering our own toasters together in the age of iPhones. Value traps are passive failures. A company failed to act in response to some macro event. Value graveyard stocks are active traps. Management at these companies is either actively working to destroy value (and line their pockets in the process), or working to create value that shareholders can't partake in.

Many companies in the value graveyard trade on the pink sheets and file financial reports occasionally, or never at all. It's much easier to hide what's happening if you don't give financial updates. The best way to identify a value graveyard situation is one where management is clearly running the company for the benefit of themselves. They earn a large salary, issue shares to themselves and regard shareholders as an annoyance.

When a company's management takes such a negative stance against shareholders it's no surprise that shareholders give up and sell the stock en masse. Sometimes these stocks are illiquid because there are no buyers for such a terrible company. Other times these stocks are illiquid because the company won't give out financials without an NDA, and for 99.999% of the market that is too high of a hurdle to overcome to invest.

Given enough time companies in the value graveyard atrophy. Sometimes management is able to destroy (or take) value quicker than the share price falls. But other times the price falls quicker than the slow decline initiated by management. It's in the atrophy mismatch where opportunities arise for investors who wish to get their hands dirty.

Before the US Senate Benjamin Graham was asked why undervalued stocks eventually appreciated to fair value. Graham responded it was a mystery and that no one knew why it happened. We still don't know exactly why a given stock might appreciate, but I think we can make an assumption in general about why this happens. With millions of investors combing the world of opportunity enough eventually find an undervalued situation, purchase, and push the price up.

If a company falls to an incredibly low valuation, essentially too low of a valuation the investment can become attractive, but not by buying and patiently waiting. For companies that live in the value graveyard investors need to become personally engaged in helping to realize value with the situation. When management is working against shareholders the company's shareholders need to be working against management.

A recent example of this is Solitron Devices, a chip manufacturer based in Florida. The company went bankrupt in the early 1990s and the CEO claimed they've been emerging for the last twenty years. During this emerging period he felt it was acceptable to ignore shareholders, not hold annual meetings and continually line his pockets with a large salary and stock options. The stock price drifted downward over the years and eventually settled in net-net territory. With a price so low for so long value investors and activist investors emerged. This past week shareholders (who are predominantly value investors at this point) elected two activist investors from Eriksen Capital Management to the Board. With this management suddenly decided to start thinking about value creation. They initiated a large buyback and have begun talking about mergers or selling. Of course what happens verses what is discussed remains to be seen, but this is a step in the right direction. Shareholders have pushed back forcefully against management, and with only a minority ownership stake management is forced to act.

In the most recent issue of the Oddball Stocks Newsletter I highlighted another value graveyard situation that has finally attracted investor interest. I will post the name here eventually after subscribers have an opportunity to purchase, but the company is attractive. Like Solitron the majority of their market cap is in liquid assets that can be sold for a multiple of the current price. The issue with this company is management is trying to hide these assets and keep them for themselves. They require shareholders to sign an NDA to receive the annual report, and prefer to operate in secrecy rather than honestly in the daylight. But like Solitron investors have taken notice of the extreme mis-valuation and have decided it's time for something to be done, and push back against management.

When an investor comes across a company in the value graveyard they have a choice, pass by, or do something. Larger firms with significant resources might consider buying a stake an actively pushing for value creation. Individual investors like myself can alert other investors to these types of situations. You don't have to be an established activist with a large capital base to make a difference. Sometimes a letter to management letting them know shareholders exist can be enough, or a short article in the local paper. A little sunlight on a dark situation is never bad for shareholders, but is feared by management.

So how much mismanagement can an investor stomach before running for the hills? I talk about how I evaluate management more in my free investing mini-course.